Solution Preview

Before answering the questions we need to be clear as to what is needed to take care of externalities and the following theorem due to Nobel laureate Robert Coase of University of Chicago gives the precise requirements:

"If there are zero transaction costs, the efficient outcome will occur regardless of legal entitlement.....If there are positive transaction costs, the efficient outcome MAY NOT be reachable under every choice of legal entitlement. Where this is so, THE PREFERRED LEGAL RULE IS THE ONE THAT MINIMIZES THE EFFECTS OF TRANSACTION COSTS, including both the costs themselves and their effects i.e. inefficient choices." Source: http://law.gsu.edu/wedmundson/Syllabi/Coase.htm